Risks and Rewards

When executed under the right circumstances, swaps can help institutions achieve financial goals.

By Paul Clemente

Not entirely clear on the complexities of swaps? With more debt being issued than ever before, it’s a good time to become familiar with this little-understood transaction that could greatly benefit your institution.

Swaps Indices

Swaps are commonly based on two indices:

Percentage of LIBOR. This establishes the rate for the variable side of the swap at a certain percentage of the London InterBank Offering Rate. LIBOR rates are set for one, three, or six months or for one year. Although the LIBOR swap rate is lower than the BMA Index swap rate, the borrower assumes the basis/tax risk. Historically, tax-exempt debt has traded at approximately 67 percent of LIBOR.

Bond Market Association Index. The borrower receives—or the counterparty pays—the national average BMA Municipal Swap Index rate, which is reset weekly. This type of swap has a higher rate than a LIBOR swap because the provider assumes the basis/tax risk.

Bentley College, Waltham, Massachusetts, had a 50/50 fixed-to-variable-debt mix in December 2002 and was enjoying very low floating variable interest rates. Fixed rates on new money were also at historic lows. The college had variable rate debt due in 2028 that carried balloon payments. Concerned about the prospect of much higher rates in the future, members of Bentley’s business and finance committee decided to fix some of the existing variable rate debt at low levels. The committee voted to change the fixed-to-variable-rate mix to 67 percent/33 percent and selected a fixed-rate swap to achieve this new ratio. As a result, the college entered into its first fixed-rate swap for $25 million at 3.69 percent for 28 years.

Interest-rate swaps, also known as derivatives, are transactions between two parties where one party agrees to exchange floating-rate payments for fixed-rate payments—or vice versa. A fixed-rate swap converts variable debt into fixed debt, and a variable-rate swap essentially converts fixed debt to variable debt.

Investment bankers often define an interest-rate swap as a contract between two parties for the exchange of cash flows for a predetermined time. Most colleges and universities, for example, enter into swaps with financial institutions that hedge their position by entering into offsetting positions, including reverse swaps and shorting treasury securities.

Swap definitions do not mention bonds or debt—and for good reason. Although traditionally tied to existing or future debt, swaps are completely separate transactions. An institution can enter into a swap whether it has debt or anticipates issuance of debt. Even if it has no debt, an institution may find the swap financially beneficial or may want to hedge some other transaction.

A swap does not affect existing bond documentation or change the obligations to bondholders. Regardless of other transactions the institution has entered into, bondholders expect to be paid (see Figure 1).

Figure 1One Way or Another

What You May Gain

Why execute a swap? For Bentley College, doing so enabled the institution to achieve fixed-to-variable-rate-debt policies. Those policies, set by the board, aim to align liabilities with earnings from assets.In addition, as Bentley quickly discovered, a swap enabled it to:

Achieve the lowest possible interest structure, within policy constraints. In October 2003, Bentley needed $30.1 million in new capital to finance construction of residence halls. Issuing variable-rate debt, however, would exceed the 67 percent/33 percent debt policy set by the board. The college considered issuing fixed-rate debt but found that fixed-interest rates were 80 basis points (bps) higher than the same debt via a fixed-rate swap.

Ultimately, Bentley entered into a fixed-rate swap for $15 million at 3.63 percent, effective until 2030. This preserved the board’s debt policy while reducing the costs of debt service. It also had an immediate, positive effect on the annual budget.

Mitigate interest-rate risk in favor of budget certainty. Bentley needed $15 million in new capital to finance two construction projects in October 2005. Working within the existing debt policy, the college had planned to issue variable debt. A few months earlier, however, 67 percent of LIBOR swap rates (see box, “Swaps Indices”) had dipped to 3.31 percent—a rate that was not only historically low but was also attractive to the board.

Taking advantage of the low rate, Bentley entered into a forward fixed-rate swap for $15 million in September, to be effective one month later. (A forward swap is one that will take effect at a future date.) One month later in October, $15 million in new debt was issued for 27 years. This swap resulted in a 94 percent/6 percent fixed-to-variable mix.

Reduce costs while working within limitations of bond refunding. In 2005, the Bentley balance sheet held $45.6 million HEFA J, fixed-rate debt due in 2028 and carrying an average coupon rate of 5 percent. HEFA J already included a refunding of prior debt. Based on IRS rules, only the non-refunded portion of this debt, which was small, could be advance refunded before July 1, 2008.

Making a Statement

A swap is independent of any underlying debt and is tradable—either between the issuer and counterparty or to an otherwise independent third party. Accordingly, it has a financial value. FAS 133 requires that you report the market value of the swaps in audited statements and in notes to the financial statements. The value of the swap is shown as an asset or liability on the Statement of Financial Position; the change in this valuation appears in the non-operating section of the Statement of Activities.

Ups and Downs

Theoretically, on the day that an interest-rate swap is executed, it should have no financial statement implications. As interest rates change, however, the value could go up or down, much like the market value of bonds. For instance, interest rates declined substantially following the execution of Bentley’s first swap in 2002. Three years later, the 2002 swap—for which the college agreed to pay the counterparty 3.69 percent—could be obtained by paying 3.31 percent.

If the college wanted to terminate the swap, it would need to pay a premium to the counterparty. This premium is recorded as an asset on the books of the counterparty and as a liability on Bentley’s financial statements. Much like holding an investment in a standard fixed-income security, the premium will be neither due nor payable if Bentley holds the swap until the end of the contract period.

During periods of rising interest rates, liabilities can quickly turn into assets: What was bad news one year becomes good news the next year. Should the market value of the swap turn substantially positive, the agreements generally allow the issuer (the college)—but not the provider—the option to terminate the swap. Upon termination, the issuer receives a cash payment from the provider, which again leaves the issuer subject to the market interest conditions for the underlying debt.

The market value of Bentley’s swaps has fluctuated between positive $100,000 and negative $11 million—a financial implication that Bentley’s business and finance committee fully understands and accepts.

Putting It in Writing

Here’s a sample of the note that Bentley includes in its financial statements:

“The College entered into an interest-rate swap agreement with a financial institution counterparty in December 2002 on a portion of HEFA Series K variable rate bonds. The purpose of the agreement was to swap the variable rate on $25,000 of the HEFA Series K bonds for a fixed rate of 3.69 percent, for the remaining life of the bonds (28 years).

“The College entered into this agreement to manage the cash flows attributable to interest payments on the HEFA Series K bonds and does not use such instruments for speculative purposes. The swap’s fair value, and changes therein, are reported on the Statement of Activities. The value of the swap instrument represents the estimated benefit or cost to the College to cancel the agreement as of the reporting date and is based on the option-pricing models that consider risks and other market factors.

“The liability, representing a decline in value of the agreement, has been charged to the unrestricted net assets on the statement of activities for the year ended June 30, 2003, in the amount of $2,180,000.”

With interest rates at historic lows, the college wanted to lock in low rates similar to what could be achieved through an advance refunding. The solution: Execute a swaption. As its name implies, a swaption is combination of an “option” and a “swap.” The option component of this transaction involves the issuer (in this case, the college) giving the third party—in exchange for a cash payment—the option to require that the issuer refund its debt at a certain date in the future (in this case, July 1, 2008). The swap component of the transaction involves the issuer entering into a forward swap with the third party (counterparty) at a certain interest rate.

Bentley’s swaption was evaluated like a fixed-rate refunding: The counterparty immediately paid Bentley $3.2 million in cash. In exchange, Bentley agreed to provide the counterparty with the option to require that the college refund HEFA J on July 1, 2008. Should the option be exercised, Bentley will refund HEFA J, issue variable-rate debt, and enter into a forward swap with the counterparty where Bentley pays 5 percent fixed and the counterparty pays Bentley 67 percent of LIBOR.

Because future budgets assumed 5 percent interest for HEFA K, this transaction had no effect on financial forecasting. Bentley’s endowment, however, increased by $3.2 million—an amount that belongs to the college whether or not the option is exercised. The $3.2 million is the valuation placed on the deal by the counterparty based on assumptions regarding future interest rates and other considerations.

Eyes Wide Open

Swaps are not difficult to execute, and they have minimal costs. They enable you to exercise a hedge strategy with interest rates—you can take advantage of low rates without being exposed to floating rates. Depending on an institution’s situation, however, a swap may not be the best choice.

On two occasions in 2004, Bentley evaluated whether to enter into a swaption and decided against the deal. In the first instance, a bond market rally substantially reduced the cash payment. In the second case, the cash payment, which would have been below $2 million, was not considered sufficient enough to tempt the college.

When evaluating the various risks, determine how entering into swaps and swaptions might impact the institution and whether both management and the board are comfortable with the risks being assumed. One of the biggest concerns of rating agencies is that institutions using interest-rate swaps fully understand the implications. Public institutions, for example, may need to fulfill certain requirements set by state legislatures.

To ensure there are no surprises, review the following list of common, identifiable risks. Many other subtle risks may also accompany a swap transaction, so be sure to consult your institution’s investment bankers, financial advisers, and lawyers.

Basis/tax risk: This risk applies to LIBOR-based swaps. Investment-grade, tax-exempt debt traditionally trades at approximately 67 percent of LIBOR. For example, if LIBOR is 5 percent, then investment-grade, tax-exempt debt should be expected to trade at 3.35 percent (67 percent of 5 percent). Being imperfect, markets frequently trade above or below this expectation.

Using Bentley’s first swap as an example, the college agreed to pay the counterparty 3.69 percent fixed, and the counterparty agreed to pay 67 percent of LIBOR. The college is still obligated to make interest payments on the outstanding variable-rate debt. Should the outstanding debt trade higher than 67 percent of LIBOR, the college must pay the difference. This is known as basis risk.

Changes in tax rates (tax risk) as well as market conditions can also cause variations from the expected 67 percent of LIBOR average. Suppose tax rates decrease—the advantage of earning tax-free income is lessened and tax-exempt debt will trade at higher interest rates. The risk can be mitigated by entering into a BMA swap (see box, “Swaps Indices”) or by entering into a swap at a greater percentage of LIBOR.

Before Bentley entered into its first swap, its business and finance committee reviewed the impact of basis risk by examining a 20-year history of LIBOR and tax-exempt debt trading. Over the long run, the debt traded at an average of 67 percent of LIBOR (see Figure 2). Although the 20-year BMA average was less than 67 percent of LIBOR, the synthetic fixed rate offered by the counterparty for the BMA swap was 84bps higher. The committee, believing that the extra cost of a BMA swap was not warranted, was willing to accept the basis risk. Committee members also determined that the risk of tax rates going down was small.

Termination risk: Typical swap contracts allow for termination should the institution’s bond rating slip to a predetermined benchmark. For example, Bentley’s bond rating would need to experience three downgrades before the college faced contract termination. The business and finance committee has confidence in the college’s ability to maintain its bond rating and does not perceive termination to be a high risk. Because declines in bond ratings usually relate to deteriorating financial conditions, a college would need to pay the counterparty the market valuation of any swap liability should contract termination occur.

Counterparty risk: This is the risk that your counterparty will have financial difficulties and be unable to satisfy its obligations—especially if the institution elects to terminate the swap when it has a high asset valuation. In this case, the counterparty would owe the college a termination payment. To reduce this risk, the committee spread the college’s swaps between two highly rated counterparties. In addition, management regularly evaluates the counterparties to ascertain the stability of their financial condition.

Collateralization risk: Swap contracts typically have collateralization requirements: Should the liability of either party exceed a predetermined amount, the party recording the liability on its books must post collateral to cover the liability.

In other words, unless you have a swap contract with one-way collateralization, your institution may need to post collateral should the market value of the swap reach a predetermined liability level. In Bentley’s case, two counterparties agreed to terms that limited the probability that Bentley would have to post collateral in the future.

Figure 2 The Historical Context

Historical Information

Low Point

AverageSince 1986

Current Rates (1/5/2006)

BMA Averages

30 Year Treasury

4.17% (6/13/03)

6.75%

4.55%

Current

2.93%

Revenue Bond Index

4.72% (6/02/05)

6.29%

5.09%

1-Year

2.47%

1 Month LIBOR

1.00% (6/25/03)

5.13%

4.42%

5-Year

1.75%

BMA Index

0.70% (7/10/03)

3.51%

2.93%

10-Year

2.66%

15-Year

2.86%

25-Year

4.11%

Documenting the Deal

The details of all swaps are documented under the International Swap Dealer’s Agreement Master Agreement. Many of the terms—including interest rates, collateralization limits, and termination thresholds—are negotiable. Before finalizing a swap agreement, be sure to:

Engage a legal professional to assist with the contract.

Look into receiving better terms and rates by accessing more than one counterparty. By working with two counterparties, Bentley not only received the best terms offered by each but also spread the counterparty risk.

Communicate your understanding of the vehicle to the board, and confirm their understanding of its risks and implications. Remind them, for example, that the valuation of swaps will affect the balance sheet and income statements (see sidebar, “Making a Statement”). The concept of interest-rate swaps can be difficult to grasp, especially for trustees without a financial background.

Although they are not without risk, swaps offer institutions a convenient tool for achieving financial goals. In three years, Bentley has moved from having 50 percent variable-rate debt to having 6 percent. A weighted average cost of capital less than 4 percent effectively positions the college to meet its future goals.

PAUL CLEMENTE is vice president for business and finance and treasurer, Bentley College, Waltham, Massachusetts.